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Bad Debts

American Mortgage Crisis Rattles German Banking Sector

By Frank Hornig, Lothar Pauly and Christian Reiermann

Germany has bailed out one bank burdened with American "subprime" mortgage risks, but the fun may not be over -- as the earthquake in world markets this week demonstrates.

The saviors of the German financial sector came together early this month in a sterile conference room at the Düsseldorf headquarters of the IKB commercial bank. The head of Germany’s state development bank KfW, Ingrid Matthäus-Maier, looked anxious. Jörg Asmussen, a departmental head at the Finance Ministry, wrung his hands. His boss, Finance Minister Peer Steinbrück, called from his home in Bonn; other top leaders of German banks were also listening in.

Germany had been hit by a version of the crisis that surprised French investors on Thursday, sending stock markets from New York to Tokyo into unexpected dives. Debts arising from America's so-called subprime mortgage sector had just caused IKB to falter.

The most thankless job fell to Matthäus-Maier. She had to tell those in attendance that KfW’s stake in IKB was in an unforeseen predicament. The niche bank specializes in the rather dull sector of financing mid-sized companies; but recently it had taken on risky investments in the United States. The bank’s management made some bad bets, and lost. Now it was teetering on the edge of insolvency, unless other German financial institutions chipped in with emergency funding.

Jochen Sanio, president of Germany’s banking supervisory agency BaFin, was pessimistic: If IKB folded, the failure might spread to other institutions, and maybe set off the biggest bank crisis since the Great Depression in the 1930s. Bundesbank President Axel Weber was less bleak, but made another troubling prediction: A chain reaction could endanger Germany’s banking reputation. The gathering of bankers and government officials decided to undertake the biggest rescue operation for a single bank that Germany has ever seen.

American Dreams Gone Sour

The epicenter of this financial quake is the United States. Hardly a day passes now when an American mortgage lender or hedge fund doesn’t go belly-up. The world’s equity markets first plunged in response to the crisis in mid-July. Germany’s leading stock index, the Dax, lost over ten percent in a matter of days, and America’s Dow Jones dropped six percent.

Another round of panic hit world markets this week after a French bank, BNP Paribas, had to freeze three investment funds worth €2.76 billion ($3.79 billion) because of American mortgage debts. The Down Jones fell three percent on Thursday, and central banks in the US, Europe and Japan have injected money markets with billions of dollars to ease credit jitters.

The crisis has even started to frighten US consumers, whose joy in spending has until recently the bedrock of the world economy. They’re not just victims in this story, but also the cause of the mess. They’ve built and bought big new houses on easy credit without thinking about potential consequences. This was not a problem as long as real estate values climbed, allowing them to take out ever-larger housing equity loans. But the overheated US housing market started to crash this year, putting an end to the carefree days of American homeownership.

Rising house prices in America started a craze for "subprime" mortgages, or housing loans offered to homebuyers below the prime lending rate. Typically these loans involve a low-rate grace period before a higher rate comes into effect. And as long as housing prices boomed, debts associated with these mortgages could be packaged as attractive investment vehicles for big institutions. But now the market has stalled and abundant credit for such risky investments has dried up -- and anyone, apparently, can run into trouble.

One Bank's Quick Decline

In mid-February, the leadership of the Düsseldorf-based IKB was still boasting of “noticeable successes in the department for real estate customers.” But IKB had jumped into the real-estate business long after many market players had cashed in and jumped out.

At the bank’s last supervisory board meeting before the crisis went public, two supervisors asked the board whether IKB was properly covered for bad housing loans in the United States. How big were the potential risks? Participants at the meeting remember IKB Chairman Stefan Ortseifen saying: “There is no risk.” Two special audits by the Auditing Association of German Banks -- the last one in spring -- also found nothing unusual.

But the house of cards was brought down two weeks ago by Deutsche Bank, which ended the line of credit for Rhineland Funding, an innocent-sounding investment vehicle based in the American state of Delaware. IKB had securities holdings there and in another fund worth more than €20 billion ($27.6 billion).

Deutsche Bank had handled Rhineland’s payment transactions and some of its financing. After canceling the line of credit, the bank alerted regulators at BaFin, the German supervisory agency. It became clear during subsequent crisis meetings examining IKB’s credit liabilities that the humble bank had losses totaling between €2.3 billion to €2.5 billion at current market conditions. “They were broke on Monday,” says a board member.

Expecting further liabilities to surface, regulatory boss Sanio went around the summit meeting in Düsseldorf with his proverbial hat in his hand. In the end, the state-backed development bank KfW, as principal shareholder in IKB, would have to cover the €2.5 billion in potential losses. Germany’s private banks offered €500 million. The nation's credit unions and public savings banks are expected to pony up another €500 million.